Riley: Buffett, Stock Market, and Bitcoin

Warren Buffett is the master and recently amidst Bitcoin and stock market mania he has been asked to opine on the activity. Sadly Mr. Buffett is currently talking out of both sides of his mouth. While his advice is delivered in the usual humble homespun style he is famous for, the message is confusing and potentially dangerous to vulnerable investors.

Mr. Buffett has long advised average individuals to invest for the long term using low-cost index funds or ETFs. Saving money and investing in America is key. That remains Buffett’s advice today. But aren’t there points in time when “Mr. Market” is behaving irrationally? Of course, there are! Buffett has opined on several occasions about market valuation and the odds of prospective above or below average returns.

Buffett has repeatedly focused attention on his favorite indicator known as “The Buffett Indicator” The indicator compares Total Stock Market Capitalization relative to US GDP. That indicator spooked him in the late 1990s early 2000s.

This Time is Different

As can be seen from this chart, we are now at a level in this indicator that has many followers very concerned. But Buffett has for some time explained that the low-interest rate environment has existed far beyond his predictions and expectations. Admitting he does not understand why rates are so low and so persistent he now values stocks using a much lower discount rate thus increasing the present value of earnings and the present value of the stock market.

What is the discount rate he uses? What was it? We know that he has repeatedly warned that public pension plans are severely underfunded and are inappropriately using projected compounded returns as high as Providence’s 8% when they should use something closer to 5 %.

So, how does that square with his current expectations of a low-interest rate environment? What kind of return does Buffett expect going forward? Is he telling us to invest?

Both Buffett and Graham clearly think that this time is different and now suddenly neither expert can estimate the current value of the Dow within tens of thousandths of points. Is it worth 26,000 today or 50,000? Sounds a bit like Bitcoin, doesn’t it? People are greedy and will obviously prefer Jeremy Grahams melt-up scenario to his “official” seven years of losses scenario.

In Buffett’s new low-interest rate paradigm, valuations based on a discounted cash flow model, as his mentor Ben Graham (no relation to Jeremy) might have done become wildly variable as risk-free interest rates go towards zero. How should we value future earnings and dividends in a negative interest rate environment? Is it possible that the fair value could be infinite, if earnings continue to grow at double digits and rates go negative?

Stock Market performance is now front-page news and investors are right to question, “Is the stock market too high? Should we expect more 20% annual returns?"

Similar to the Bitcoin frenzy, the more we listen to the so-called experts, the more confusing it all becomes. Are there really any experts? Does anyone know what the stock market will do over any given period of time? The answer is a flat out ….NO!

My Two Cents

As a professional trader, hedge fund manager and investment advisor for the last 40 years I have learned quite a few things and I have a few rules.

Know what you don’t know.

Be humble and don’t overcommit.

Understand and manage your own risk

These rules apply to trading and investing for the longer term. The rules apply to everyone regardless of knowledge, intelligence or experience. This does not mean for investors to ignore experienced advice or academic theory. Be humble, realize that there are points in time where the odds are in your favor, or that you have a unique understanding of an investment and its probability of being profitable. There are also times to take money off the table and reduce risk.

Michael G. Riley is vice chair at Rhode Island Center for Freedom and Prosperity and is managing member and founder of Coastal Management Group, LLC. Riley has 35 years of experience in the financial industry, having managed divisions of PaineWebber, LETCO, and TD Securities (TD Bank). He has been quoted in Barron’s, Wall Street Transcript, NY Post, and various other print media and also appeared on NBC News, Yahoo TV, and CNBC.

Recently, a proposal has been made to permit the issuance of $81 million in bonds by the State to build a new stadium for the Pawtucket Red Sox. If there was an election today on this issue, would you vote to approve or reject issuing $81 million in financing supported moral obligation bonds to build the stadium?

The next question is about the total income of YOUR HOUSEHOLD for the PAST 12 MONTHS. Please include your income PLUS the income of all members living in your household (including cohabiting partners and armed forces members living at home).